Cost Drivers to Apportion the Production Overheads to the Units Produced - Essay Example

MANAGEMENT FINANCE: BERRY LTD. By Question A Activity based costing (ABC) method is costing a method, which utilizes cost drivers to apportion the production overheads to the units produced. Thus, the rationale on which ABC is based is that, costs drivers cause costs to be incurred during production; therefore, according to the proponents of ABC, it is justifiable to allocate overheads to production units based on cost drivers, which take into account the costs absorbed by individual products as opposed to using an absorption rate that allocates costs to products using a pre-determined figure (Krishnan, 2007). Thus, to go deeper, cost drivers refers to activities, which cause costs to be incurred (Yahya-Zadeh, 2011). Some of these activities would include; the number of purchase orders, the number of machine set ups, the number of batches, the number of machine hours as demonstrated below among many others. For instance, Offenbacker (2004) argues that, “the product costs are much more accurate under ABC– although overhead costs will NEVER be accurate because they are INDIRECT costs since the overhead to be absorbed is exactly the same overhead but analysed differently.” Moreover, Sharman (2003) argue that, “the potential implication of applying ABC system in the company is that there will not be product cost distortion and will provide the more accurate and that resulted in better product pricing and more accurate evaluation of the relative profitability of the products” (Roztocki et al., 1999). Conversely, during the production process different product lines and products use overhead resources at substantially different rates, thus, a slight change in the mix of products can result to dramatic changes in costs, which cannot be accurately predicted using the absorption costing method, hence, leading to making of incorrect buy or make decisions. Therefore, this can demonstrated by the reports below for both ABC and absorption costing method. Berry Ltd Budgeted Production and Sales Product X Y Z Total Batch size (units) 500 800 400 1700 Purchase orders per batch 4 5 4 13 Machine hours per unit 1·5 1·25 1·4 4.15 Budgeted Units 20000 16000 22000 Total machines Hours 30000 20000 30800 80800 Cost Allocation Based on Cost Drivers Product Total X Y Z Machine set up costs-No. of Batches 280,000 500/1700*280, 000=82,352.9 800/1700*280, 000=131,764.7 400/1700*280, 000=65,882.4 Material ordering costs-No. of pur. orders 316,000 4/13*316,000= 97,230.8 5/13*316,000= 121,538.5 4/13*316,000= 97, 230.8 Machine running costs-No. of Machine Hours 420,000 30000/80800* 420000= 155,940.6 20000/80800* 420000= 103,960.4 30800/80800* 420000= 160, 099.0 General facility costs- No. of Machine Hours 361,000 30000/80800* 361,000 134,034.7 20000/80800* 361,000 89,356.4 30800/80800* 361,000 137,608.9 Berry Ltd Budgeted Production and Sales Based on ABC Method Product X Y Z Direct Costs £ Per unit £ per unit £ per unit Direct materials 25*20,000 28*16,000 22*22,000 =500,000 =448,000 =484,000 Direct labour (£12 per hour) 30*20,000 36*16,000 24*22,000 =600,000 =576,000 =528,000 Prime Cost =1, 100,000 =1,024,000 =1,012,000 (Total Direct Cost) Apportioned Overheads Machine set up costs =82,352.9 131,764.7 65,882.4 Material ordering costs =97,230.8 121,538.5 97, 230.8 Machine running costs =155,940.6 103,960.4 160, 099.0 General facility costs =134,034.7 89,356.4 137,608.9 Total Overhead Cost = 469,559 446,620 460,821.1 Total Cost= =1,569,559 1,470,620 1,472,821.1 Cost Per unit =1,569,559 /20000 1, 470,620/16000 1,472,821.1/22000 =£78.5 =£91.9 =£66.9 Therefore, based on the new method, the ABC system the cost per unit of the products produced by the company based on the budgeted number of products for the three products will be as determined above; X=£78.5; Y=£91.9; Z=£66.9. However, based on the old technique of absorption costing the cost per unit of the products will be as shown below. Berry Ltd Budgeted Production and Sales Based on Absorption costing Overhead absorption rate=Total overheads/Total Direct Labour hours Product X Y Z Direct Costs £ Per unit £ per unit £ per unit Direct materials 25*20,000 28*16,000 22*22,000 =500,000 =448,000 =484,000 Direct labour (£12 per hour) 30*20,000 36*16,000 24*22,000 =600,000 =576,000 =528,000 Prime Cost =1, 100,000 =1,024,000 =1,012,000 (Total Direct Cost) Overheads Absorption =485,000 =465,600 =426,800 Total Costs =1,585,000 =1,489,600 =1,438,800 Cost per unit 20,000 16,000 22,000 =£79.3 =£93.1 =£65.4 Workings Product X Y Z £ Per unit £ per unit £ per unit Direct labour (£12 per hour) 30/12=2.5hrs 36/12=3hrs 24/12=2hrs Total number of hours 20000*2.5 16000*3 22000*2 50,000 48,000 44,000 Total direct labour hours=142,000hours Overhead absorption rate=1,377,400/142,000=9.7 Therefore, based on the cost per unit figures determined from the above, the products have a unit costs of X=£78.5; Y=£91.9; Z=£66.9 under the ABC system while under the current absorption costing system the products have units of X=£79.3; Y=£93.1; Z=£65.4. Thus, from the analysis it is evident that ABC method is an efficient method for allocating overhead costs than the absorption method since it yields to lower costs for products as evidenced by products X=£78.5 and Y=£91.9 vs. =£79.3 and Y=£93.1 because it efficiently apportions the overhead costs to the three products based on their consumption rates using the cost drivers. Moreover, Product Z has also a higher cost per unit of £66.9 under the ABC method compared to that absorption costing, which is £65.4 a good illustration of how efficient the method is in allocating overheads to unit. Thus, despite the fact the product uses lower direct labour hours in production compared to X and Y, because it is produced in large volume 22,000 units compared to X=20,000 and Y=16,000, the product consumes much more of the costs compared to the other products hence, the higher accurate unit cost as reflected by the ABC method. Therefore, from the reports above ABC method can result to better pricing of the products compared to the current absorption costing method. Therefore, with the inclusion of the mark-up to determine the product prices, it is evident that product X and Y can be offered to consumers at lower prices compared to the previous prices and this is likely to spur profitability for Berry Ltd. That notwithstanding, because the price for Z will be accurately, determined, this can help the company to choose it production mix; produce more of the profitable products and less of the less profitable product Z under the new ABC system. Question B Businesses especially those engaged in manufacturing are organized into different departments with different departmental managers who coordinate the activities and operations of such units. Therefore, just like any other manufacturing firm, Berry Ltd need will often need to make critical business decisions regarding its operations both at the departmental level and as a whole firm. For instance, as at the production department as a company, Berry Ltd will require budgets for the purpose of planning, control, performance evaluation and motivation to be able to coordinate its activities and communicate various tasks to other departments of the firm like the sales department and other productions units if the products undergo further processing before completion. Budgeting A budget is a plan of action, which prepared for the purpose of carrying out planned tasks for a defined period (Chinweike, 2010). Some of the purposes of preparing a budget include: Planning Planning is the first step of preparing a budget, which involves the determination of the goal that the budget is meant to accomplish, in addition to, controlling the feedback system in order to ensure the plan is executed properly (William, 2003). Moreover, planning depends on the forecasts made to determine the levels of operation or production in the future, in addition to, to determining the amount of materials required or the production department depending on the forecasts on which planning is based (AccountingTools, n.d.). Therefore, given that management has control over the internal factors within the company such as plant and equipment, financial resources, production levels, human capital, etc., Berry Ltd should also evaluate the external factors that are beyond the companys control such as customer taste and preferences shifts that have a direct correlation with production levels and profitability. Therefore, with proper planning, Berry Ltd. can be able to determine the appropriate product mixes and levels of production through forecasts, in addition to, determining the most profitable products to produce in larger volumes (Accessmylibrary.com, n.d.). For instance, based on the new costing system the company contemplates implementing, it is recommendable that the company produces more of X and Y products and less of Z to be able to increase the levels of sales volumes to increase the profitability of the company. Control Once the planning function of the budget is complete, managers have an obligation to operate within the set limits and achieve the stipulated goals of the budget (Schmidt, n.d.). Therefore, at this stage there is need to monitor the expenses incurred in the process of production by the company in relation to the levels of the revenues generated from such activities (Northern Ireland Assembly, 2010). Thus, given the important role played by the function of control, Berry Ltd should constantly monitor its levels of production and ensure they are within he set limits as set in the budget. For instance, the set production and sales levels for the three products of Berry Ltd. are set at X=20,000; Y=16,000 and Z=22,000 as per the budgets. Therefore, if by the end of the production period the company, will not have met the budgeted targets, there will be a need for taking action to adjust the level of activities. If, for example, the demand for products X exceed the budgeted number of production units while products Z demand is below the production levels as per the budget, Berry Ltd. will have to adjust the production activities to produce more of product X and less of product Z to be able meeting the demand of the market and consequently, increase the level of sales and profitability. Thus, control is essential because it enables management to monitor company activities to ensure targets are met and appropriate action is taken when there are deviations from the budgeted activities before it is too late (Schmidt, n.d.). However, it is imperative noting that controlling can have an adverse effect on the planning purpose because management can be determined to regulate the levels of activity for Berry Ltd and thus, in the process affecting the projected levels of activity at the planning stage. Moreover, the controlling purpose can be limiting to factor to the process of production if management wish to take action when they note deviations in sales and production, which be, for instance, due to short term reasons e.g. consumers for product Z buying more during the end of the months and less of the product during other times. Evaluation Budgets are important tools for determining whether the set goals or plans were met by comparing it to actual performance (Garrison, 2012). Moreover, budgets are effective tools for evaluating managers to determine if they achieved their targets as set in budgets. Therefore, because budgets present a standard performance measure upon which activities are measures, they enable the organization to identify any deviations in the company activities from the budgeted activities (Garrison, 2012). Thus, Berry Ltd. can use the budgeted levels of production units and sales units to determine the effectiveness of the budgets by comparing it with the actual sales of the company during the period of production. Moreover, Berry Ltd can use the budgeted activity for the production department to evaluate the effectiveness of the production manager in achieving the targeted levels of activity of the company; to determine how responsible as a manager he is in achieving the goals for his department (Lapide, 2005). For instance, for the purpose of evaluation, the management of Berry Ltd. can compare the budgeted volume of sales for its three products X=20,000; Y=16,000 and Z=22,000 with the actual sales made during the period, to be able to adjust production activities for the three products depending on the demand and volume of sales made for each product. For instance, from the evaluation, Berry Ltd. would determine that under the new costing system, the most profitable products would be X and Y because of their low unit costs of production if their prices as determined by the mark-up adjustment are held constant. Therefore, this would enable management to take appropriate action by aligning production to the level of demand and sales volume for each of the product depending on their profitability and the actual sales made (Accessmylibrary.com, n.d.). However, it is imperative to note that during the process of evaluation it would be possible that the action being taken to align projected activity with actual activity, could conflict with function of planning; at the forecasting level to determine the activity levels for the period. Moreover, the evaluation function can conflict with controlling function in that management would want to control the level of production to be within the budgeted activity of X=20,000; Y=16,000 and Z=22,000 units, but because of external environmental factors, which will necessitate adjustment of production and sales activities. Motivation Motivation drives companies like Berry Ltd. to run towards implementing their plans for the projected levels of activities (Mikesell, 2003). In relation to this function of budgets, it is important noting the impact that the budget has on the motivation o staff of Berry Ltd. Therefore, in conjunction with that, two factors need to be considered here. Firstly, how can Berry Ltd. make its staff follow the budget; secondly how can Berry Ltd. set the most difficult part of the budget (Northern Ireland Assembly, 2010). That notwithstanding, there are different approaches that companies can use to make their staff adopt and follow a budget, which include the participatory and the authoritarian method. However, I would recommend Berry Ltd to adopt a participatory approach, which includes staff in formulating the budget by considering their views, unlike the authoritarian method. Thus, by following this method the staff and management will feel motivated to implement the budget at will in a bid to achieve the budget targets. On the other hand, Berry Ltd.’s budget is an easy budget to implement and therefore, I believe the company staff finds this as a motivation to ensure they are committed towards the implementation of the company’s budget. Thus, with these factors and approaches adopted by Berry Ltd., the company has a motivated staff committed to achieving the budgeted levels of production and sales for the three products X=20,000; Y=16,000 and Z=22,000 units. However, despite these advantages, its important to note that motivation as a function can conflict with other functions of budgets. For instance, the motivation to implement budget by management can conflict with function of control and evaluation in that management can have inadequate measures in place for taking action when the budgeted levels of activities deviate from the expected activities (AccountingTools, n.d.). Moreover, management ca be determined to control the levels of budgeted activity to ensure they are within the set plans and thus, in the process demotivating other staff who would be following the initially budgeted plans. Conclusion Therefore, from the aforementioned functions of budgets it is evident that each has benefits and limitations to Berry Ltd. because of the conflicting interest that arises among the different functions. However, given the crucial role that play especially in planning the production process and sales volumes, it is undeniable that budgets a necessary tool for Berry Ltd. 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